IMFSurvey Magazine: Countries & Regions

Stephansplatz in Vienna. One of the policies that helped stave off a more severe crisis in emerging Europe is the European Bank Coordination Initiative, also known as the Vienna Initiative (photo: Hans-Peter/Robert Harding/Newscom)

Strengthening the Foundations of Growth In Emerging Europe

Strong institutions built over last two decades have enhanced emerging Europe’s resilience

IMF has stood by region since the end of communism with financing, policy advice and capacity building

Need to reactivate the successful international cooperation of the 2008-09 crisis

With the focus on the problems of the eurozone, it is easy to forget that many countries in Central, Eastern and Southeastern Europe have recovered from the depths of the global economic crisis, and are now enjoying healthy economic growth.

But because of the close integration with Western Europe, the region remains vulnerable to the crisis in the eurozone periphery, and further reforms will be needed to underpin the recovery.

“At the country level, the answer is to address vulnerabilities head-on: by improving competitiveness, reducing fiscal financing needs or dealing with non-performing loans. Given its institutional capacities, I am confident that the region will yet again be able to design and implement the policies necessary to meet these challenges,” IMF Deputy Managing Director Nemat Shafik said.

She was speaking at a July 12-13 conference organized by the Joint Vienna Institute (JVI), a training center sponsored by the IMF, Austria, and other international institutions. The conference convened about 140 policymakers, academics and JVI alumni to discuss lessons learned and the challenges ahead for the countries of Central, Eastern and Southeastern Europe.

“We also need to reactivate the successful international cooperation of the 2008-09 crisis,” Shafik said. This includes the revival of the Vienna Initiative, taking into account the new circumstances for parent banks. It may also include financial support, possibly precautionary, from the international community.”

Lessons from the global economic crisis

The economies of emerging Europe were hit hard and early by the global economic crisis. The decline in Latvia, for instance, was on a scale comparable to the 1930s Great Depression in the United States, Bas Bakker, Chief of the IMF’s Emerging Economies division said. The trigger was the collapse of Lehman Brothers in September 2008, but at the root of the crisis were large capital inflows in the pre-crisis boom years.

The result of these flows was rapid GDP growth but also rising imbalances, mainly in the form of large current accounts deficits, especially in the Baltics and Balkans. When the boom turned to bust, the main reason was a drop in domestic demand rather than a drop in exports, Bakker told the audience.

While the crisis was severe, leading to a steep rise in unemployment and a massive drop in output, banking and currency crises were largely avoided thanks to a strong policy response, large financing packages from the international community, and a commitment by foreign banks to stay in the region.

Today, current account deficits have come down, and large fiscal deficits have been reduced. But external financing requirements remain high, and there is much less fiscal space than before the crisis. Non-performing loans have risen sharply, and many countries still have to address a large stock of foreign currency loans.

Bakker pointed to five key lessons from the global economic crisis:

• Strive for more balanced growth―credit booms are not good for longer-term growth

• Keep credit growth in check and avoid a buildup of non-performing loans

• Discourage foreign currency lending

• Limit expenditure growth during good times

• Beware of “this time is different” stories

The main lesson countries should take away from the crisis is the need to build up cushions in good times. It’s good to have a pillow to fall on, said Richard Boucher, Deputy-Secretary General of the OECD. “Cushions determined who did well during the crisis, and who did badly.” He encouraged countries to rely less on capital flows and more on foreign direct investment.

Western Europe would do well to look to Central and Eastern Europe when seeking to address the eurozone crisis, according to Simeon Djankov, Bulgaria’s Deputy Prime Minister and Minister of Finance. Western Europe is not ready to accept even short-term pain, he said, warning that the European social model cannot be sustained without reforms.

“We have relied on debt and now realize this is not sustainable. Now we need to focus on spending tax payers’ money in more sustainable manner,” Austrian Finance Minister Maria Fekter said. The euro area must also draw the necessary conclusions from the crisis, she added, noting the need for further integration, including in the form of a banking union.

Solutions must be country-specific―there are no universal recipes, said Leszek Balcerowicz, former Deputy Prime Minister and Minister of Finance of Poland. He encouraged policy makers not to disregard the short-term confidence effect of structural reforms. Effects don’t just show up in long term, he said. Markets like well-designed reforms that are being implemented.

Restoring and sustaining financial stability

One of the policies that helped stave off a more severe crisis in emerging Europe is the European Bank Coordination Initiative, or Vienna Initiative, as it is more commonly known. Originated in early 2009 to help prevent a disorderly unwinding of financial exposures by commercial banks in the countries of emerging Europe, the initiative helped solved a classic prisoner’s dilemma by coordinating a common response in the private sector.

There was not a single foreign-owned subsidiary failure in the region, according to Piroska Nagy, Director for Country Strategy and Policy at the European Bank for Reconstruction and Development, which played a pivotal role in developing the Vienna Initiative. “It is astounding that there was no major financial sector crisis. In part, that was thanks to IFI [International Financial Institutions] coordination. So really, it worked,” she said.

Now in its second phase, Vienna 2.0 is seeking to ensure that deleveraging in central Europe by Western European banks takes place in an orderly and coordinated fashion. This is of paramount importance, given that foreign banks control more than half of the banking systems in most of Central, Eastern, and Southeastern Europe. New challenges include ensuring more diversity in ownership, fostering more local banking, and developing a more balanced funding model, Nagy said.

One concern is the refinancing needs of banks in the region. The European Central Bank’s Long Term Refinancing Operation (LTRO) helped with the massive refinancing needs in early 2012 but refinancing constraints will remain a big issue for some time to come, Austrian Central Bank Governor Ewald Nowotny said.

Another concern is that the new prudential rules of Basel III will complicate the development of a new banking model in the region by accelerating the deleveraging process. The problem is that the new guidelines, primarily designed for advanced economies in response to the global financial crisis, may have unintended negative consequences on both future market development and cross-border relationships that are crucial in emerging Europe.

“I worry about the accelerated implementation of the Basel III rules,” said Jacques de Larosière, former IMF Managing Director and former President of the European Bank for Reconstruction and Development. After periods of excessive credit growth, it is normal for everybody to look at their balance sheets. But the process has been precipitated by the markets, and it is having a negative effect on the ability to distribute credit. There is no rationale behind it. It has to do with superficial stigmatization of the so-called under-capitalization of banks, he said, adding that he had never seen an economy pick up without some expansion of credit.

Defining a new growth model

The growth model that prevailed in emerging Europe before the 2008 crisis was characterized by very buoyant domestic demand, and the fact that there was almost no relation between export growth and GDP growth, Deputy Director Aasim Husain in the IMF’s European Department said.

Whether a country managed to expand exports was unrelated to economic performance during the boom. Instead, economic growth was driven by a very rapid expansion of credit, fueled by massive capital inflows, he explained.

The experience of central European countries, such as Poland the Czech Republic, were an exception to this rule, however. Here, export growth kept pace with import growth, thereby keeping external imbalances―and hence vulnerabilities―more manageable. These countries grew a little more slowly, but were also hit much less hard by the crisis.

So what would a more sustainable growth model look like, Husain asked? For one thing, countries will have to rely more on domestic funding in future. They would also need to build up their export sectors. This process is already well underway in the Baltics, where exports are driving the recovery, and also in parts of Central Europe where the external orientation of the economies there is relatively higher than even before the global crisis, he said.

Given the importance of economic growth to achieving sustainable fiscal consolidation, countries should seek to identify those reductions in spending that will hurt growth the least while delivering the necessary savings, said Director of Policy Strategy and Coordination Elena Flores from the Directorate General for Economic and Financial Affairs of the European Commission. Flores also stressed that structural reforms must accompany fiscal consolidation.

“We do not need a new growth model,” Professor of Economics Thorvaldur Gylfason from the University of Iceland said. “What we need is to put in place policies, and in particular institutions that should have been put in place years ago. We need more Europe, not less Europe. But shared sovereignty is no bed of roses.”

The second day of the conference was focused on the international community’s broader capacity development agenda, and more specifically the role that the JVI could play as a training provider in a region that is undergoing rapid change. Panelists discussed what lessons could be learned from the JVI’s past two decades of operation and how to meet the challenges posed by the crisis.

The Annual JVI lecture on “Growth and the Smart State” was delivered by Professor Philippe Aghion of Harvard University.

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